Tax Bills Pose Big Threats to Investors, Little Gain to Government

Published September 27, 2013

There is a threat to the capital markets and financial industry from two proposed tax bills—one addressing carried interest taxation as it relates to investment managers, and the other a proposed tax on financial transactions. Behind these specific threats, however, is the broader overarching issue that helps set the stage for harmful tax legislation such as these bills: the growth of government.

Big Chunk of GDP

Large governments require vast amounts of money. This puts most elected officials on a continual hunt for additional revenue. The farther they prod to extract funds, the more they upset established business activity and taint pricing mechanisms that facilitate an efficient economy.

Prior to 1913 and the passage of the Sixteenth Amendment allowing the collection of income taxes, federal tax collections were minimal, consisting primarily of excise taxes and tariffs on goods and short-lived income taxes. Those taxes were often put in place or increased to fund war efforts and then rolled back after the wars ended. However, with all stops cleared for the collection of the income tax in 1913, and the ushering in of the Progressive era of politics, government has grown significantly.

From 1900 to the mid-1930s, federal government spending measured as a percentage of GDP (and not counting the brief peak around the time of World War I) was 5 percent or less. From the mid-1930s on, federal government spending increased to the peak, so far, in 2009 at 25 percent of GDP (ignoring the peak around World War II in the 1940s).

Five Times As Much Per Person

Another measure of the growth of federal government spending is per-person spending adjusted for inflation. Measured in constant 2005 dollars, according to the Mercatus Center at George Mason University, in 1948 the government spent just under $2,000 per person, consistent with historic levels. Today it is approximately $10,000 per person—five times as much.

Another measure that gives a sense of the growth in government is gross unadjusted federal outlays. In 2000 they were $1.7 trillion. In 2011, they were $3.8 trillion. And remember, this is only federal spending. These figures do not include the surge in state and local government spending.

With Spending, Taxes

Along with this big increase in government spending has been a parallel increase in the federal tax burden on individuals. When the Sixteenth Amendment was passed in 1913, the top rate was 7 percent, and it applied to incomes in excess of $500,000 (more than $10 million in today’s dollars). Only 1 percent of the population paid income tax. From there the top marginal rate peaked in 1945 at an astonishing 94 percent. Along with the growth in rates was an acceleration in the number of people who were corralled into the taxpaying ranks. From 1939 to 1945, the number of people paying income taxes increased from 4 million to 43 million. Since then, the income tax has been ingrained as a large revenue source of the federal government.

An overview of taxes would be incomplete without mention of Social Security. The payroll tax for Social Security, starting in 1935, was 2 percent on the first $3,000 of income ($50,000 in today’s dollars). It has since increased more than sevenfold, to 15.3 percent (including the Medicare portion), and the income limit has more than doubled, to $113,500. And this income limit doesn’t apply to the 2.9 percent Medicare tax.

Even with the huge increase in tax collections, the federal government has still run up debt in excess of $16 trillion and annual deficits of hundreds of billions of dollars. In addition, the entitlement programs are underfunded by tens of trillions of dollars. It is this increased spending and deficits that drives politicians to seek new revenue sources or increase existing tax rates.

Carried Interest Taxation

One possible source of new revenue politicians are targeting is the carried interest arrangement of compensation for investment managers.

Carried interests, which are also referred to as a profits interest, are a business arrangement where one partner receives a share of the income of the business venture in exchange for providing services. Unlike other partners, carrying partners provide services and do not have to contribute capital, nor do they necessarily have to be allocated any of the losses. This is where we get the term “carried,” because the other partners who provide all the financial capital for the venture are figuratively carrying the profits interest partner.

This arrangement is well-established in the tax code and applies to almost any type of business. It could be an accounting firm or law firm that wants to incentivize young executives who may not have or are not willing to contribute capital.

Tax Character Alteration

The person who has been granted the profits interest receives an allocation of profits that have the same tax character as what the venture has generated. If the venture generates ordinary income, as with accounting and law firms, the profits interest partner receives ordinary income that is taxed at a maximum of 39.6 percent. However, if the venture generates long-term capital gains, the profits interest partner receives a share of the long-term capital gains, which is taxed at a maximum of 20 percent. This is precisely what the proponents of the carried interest tax legislation want to alter. They don’t want to allow an investment manager to receive the tax character of the underlying income. They instead want all income to be ordinary.

Proponents argue the tax laws need to be changed because the services the managers perform are similar to those performed by many other persons, yet the manager is potentially compensated with capital gains that are taxed at 20 percent instead of wages taxed at a maximum of 39.6 percent.

On the face of it, it appears they have a point. Why should the manager be taxed at a rate only half of what others are taxed? I believe the case for continuing to allow mangers to receive their income with the same tax character as the venture can be made.

No Income or Inflation Protection

First, the performance income earned by a manager isn’t the same as a wage that is paid to, say, a construction worker. The construction worker will be paid, barring any extraordinary event, whether the company makes a profit or not. This is manifestly not the case for the manager.

Second, it is also important to examine why long-term capital gains rates are lower. One reason is to encourage capital formation and business activity. Another is to offset inflation. Gains build up over time. Investors could end up paying taxes on phantom profits caused by inflation. If one had invested $10,000 in 1970 and had it increase to $30,000 by 1989, the investor would have ended up paying tax on the $20,000 nominal gain even though over that time the investor actually had a net $1,000 loss in purchasing power due to inflation. A lower capital gain rate helps to lessen the sting of inflation.

Third, capital gains are double taxation of the same income stream. The valuation of a company and the price of its stock are primarily a present-value calculation of anticipated future income streams. When a stockholder sells his stock, he pays tax currently on his gain, which is directly related to the future income streams. Likewise, the purchaser then also pays income taxes when that income stream is realized in future years. Lower capital gains rates lessen the effect of this double taxation.

As you can see, there are legitimate reasons why capital gains are taxed at a lower rate than ordinary income. Politicians see this too, as they have a history of keeping capital gains rates lower than taxes on ordinary income. It seems confused and self-defeating to have a tax incentive structure to encourage activity that results in long-term capital gains but then works to exclude the people who professionally provide that function.

Big Impacts on Managers, Investors

The proposed law could potentially have a dramatic effect on investment managers. Under current law, if a manager charges a 20 percent performance fee and generates $1 million of long-term capital gains for his investors, he makes $200,000 that is taxed at 20 percent for a net after-tax gain of $160,000. If the law is changed, the top rate would go to 39.6 percent, before any surcharges for Medicare, and the manager would net after taxes approximately $121,000 instead of $160,000.

To combat this, the manager could raise his performance fee to 26.5 percent, thereby achieving the same after-tax income as before. Individual investors would be indifferent to the higher rates, as they would have received a larger share of the long-term capital gain along with ordinary write-offs so they too receive the same after-tax income even after paying the higher performance fee.

This isn’t the case with pension plans and corporate investors. Any rise in performance fee rates directly reduces their net income, as they do not have the same tax offsets that individual investors do. This creates a preferential status for individual investors over other investors. This can have implications for who gets priority into programs that have limited capacity. It could possibly be the case that pension plans would either be locked out of limited capacity programs or forced to pay a higher rate to the manager.

Possible Manager Exodus

Another outcome could be that top managers quit managing outside money. George Soros sent back outside money shortly before the Dodd-Frank regulations took effect. He specifically cited the regulations as the reason. In addition, Carl Icahn and Stanley Druckenmiller closed their services to outside investors in the face of new regulations. I would find it hard to believe that doubling the tax rate wouldn’t have the same effect, causing an exodus of managers from the alternative investment industry.

There are many aspects to this issue. However, we can distill it down to a few summary items.

The tax treatment of carried interests or profits interests is not a special tax break for investment managers. It is standard practice in many businesses, and although there possibly may be an argument for managers to not receive the underlying long-term capital gains, any change to this arrangement can cause damage by increasing the complexity of the already overly complex tax code. The American Bar Association’s section on taxation has stated, “we believe proposed carried interest legislation would add significant and burdensome complexities to the code and alter fundamental principles of partnership taxation.”

According to some estimates, the proposed legislation would raise about $2 billion a year, which is 0.05 percent of the total budget. It would fund the government for about five hours. And this doesn’t take into consideration the loss of revenue due to increased burdens on business deals and business operations.

Jeffrey V. McKinley, CPA, continues his analysis, with a focus on proposals to tax financial transactions, in the next issue of Finance, Insurance & Real Estate Policy News.

Jeffrey V. McKinley, CPA, continues his analysis, with a focus on proposals to tax financial transactions, in the next issue of Finance, Insurance & Real Estate Policy News.